TABLE 2-2 Grobaby, Inc., Balance Sheet
| Balance Sheet as of December 31, 2019 | Balance Sheet as of December 31, 2020 | |
|---|---|---|
| Total assets (TA) | $55,000 | $65,000 |
| Total liabilities (TL) | –$20,000 | –$25,000 |
| Equity (TA minus TL) | $35,000 | $40,000 |
Table 2-1 shows that Grobaby’s earnings went from $7,000 to $12,000. In Table 2-2, you can see that Grobaby increased the equity from $35,000 to $40,000 in one year. The ROE for the year 2019 is 20 percent ($7,000 in earnings divided by $35,000 in equity), which is a solid number. The following year, the ROE is 30 percent ($12,000 in earnings divided by $40,000 in equity), another solid number. A good minimum ROE is 10 percent, but 15 percent or more is preferred.
Equity and earnings growth
Two additional barometers of success are a company’s growth in earnings and growth of equity:
Look at the growth in earnings in Table 2-1. The earnings grew from $7,000 (in 2019) to $12,000 (in 2020), a percentage increase of 71 percent ($12,000 minus $7,000 equals $5,000, and $5,000 divided by $7,000 is 71 percent), which is excellent. At a minimum, earnings growth should be equal to or better than the rate of inflation, but because that’s not always a reliable number, I like at least 10 percent.
In Table 2-2, Grobaby’s equity grew by $5,000 (from $35,000 to $40,000), or 14.3 percent ($5,000 divided by $35,000), which is very good — management is doing good things here. You want to see equity increasing by 10 percent or more.
Insider buying
Noticing who’s buying and/or recommending a company’s stock
You can invest in a great company and still see its stock go nowhere. Why? Because what makes the stock go up is demand — when there’s more buying than selling of the stock. If you pick a stock for all the right reasons and the market notices the stock as well, that attention causes the stock price to climb. The things to watch for include the following:
Institutional buying: Are mutual funds and pension plans buying up the stock you’re looking at? If so, this type of buying power can exert tremendous upward pressure on the stock’s price. Some resources and publications track institutional buying and how that affects any particular stock. Frequently, when a mutual fund buys a stock, others soon follow. In spite of all the talk about independent research, a herd mentality still exists.
Analysts’ attention: Are analysts talking about the stock on the financial shows? As much as you should be skeptical about an analyst’s recommendation (given the stock market debacle of 2000–2002 and the market problems in 2008), it offers some positive reinforcement for your stock. Don’t ever buy a stock solely on the basis of an analyst’s recommendation. Just know that if you buy a stock based on your own research, and analysts subsequently rave about it, your stock price is likely to go up. A single recommendation by an influential analyst can be enough to send a stock skyward.
Newsletter recommendations: Independent researchers usually publish newsletters. If influential newsletters are touting your choice, that praise is also good for your stock. Although some great newsletters are out there and they offer information that’s as good as or better than that of some brokerage firms’ research departments, don’t base your investment decision on a single tip. However, seeing newsletters tout a stock that you’ve already chosen should make you feel good.
Consumer publications: No, you won’t find investment advice here. This one seems to come out of left field, but it’s a source that you should notice. Publications such as Consumer Reports regularly look at products and services and rate them for consumer satisfaction. If a company’s offerings are well received by consumers, that’s a strong positive for the company. This kind of attention ultimately has a positive effect on that company’s stock.
Making sure a company continues to do well
A company’s financial situation does change, and you, as a diligent investor, need to continue to look at the numbers for as long as the stock is in your portfolio. You may have chosen a great stock from a great company with great numbers in 2018, but chances are pretty good that the numbers have changed since then.
Heeding investing lessons from history
A growth stock isn’t a creature like the Loch Ness monster — always talked about but rarely seen. Growth stocks have been part of the financial scene for nearly a century. Examples abound that offer rich information that you can apply to today’s stock market environment. Look at past market winners, especially those during the bull market of the late 1990s and the bearish markets of 2000–2010, and ask yourself, “What made them profitable stocks?” These two time frames offer a stark contrast to each other. The 1990s were booming times for stocks, whereas more recent years were very tough and bearish.
Pick a company that has strong fundamentals, including signs such as rising sales and earnings and low debt. (See Chapter 4 in Book 3.)
Make sure that the company is in a growing industry.
Fully participate in stocks that are benefiting from bullish market developments in the general economy.
During a bear market or in bearish trends, switch more of your money out of growth stocks (such as technology) and into defensive stocks (such as utilities).
Monitor your stocks. Hold onto stocks that continue to have growth potential, and sell those stocks with declining prospects.